CHAPTER 12

HOW MARKETS DETERMINE INCOMES

I. CHAPTER OVERVIEW

Now that you have studied how pricing and production decisions are made in output markets, it is time to
consider how pricing and employment decisions are made in input markets. You will recall that relative
scarcity and need were seen to determine why it costs more to buy some goods than it does to buy others; but
what accounts for the large differences in the wages and salaries offered to people engaged in various
occupations? Scarcity? Need? Or something else?
Even casual consideration of any productive enterprise reveals that all inputs work interdependently to
produce a given product or service. Given this complex interdependence, how can one compute levels of
compensation that reflect accurately the importance of their respective contributions? How, more specifically,
are wage rates determined? And interest rates? And land rents? And so on?
This begins a series of chapters that focus on the distribution of income. Critical in determining the nature
of the distribution must be, of course, the ownership of the factors of production and the prices that they
command. Chapter 12 begins, therefore, with a brief introduction to what economists mean when they speak of
income and wealth, and where they look to find the sources of income and wealth in a modern economy.
There is, however, more to the distribution of income than simply cataloguing who owns what. There is,
more specifically, the question of what determines how much each factor is worth. We can find an answer to
this question using the familiar tools of supply-and-demand analysis. The fundamental differences between
product markets and factor markets lie in the sources of supply and demand components. In a product market
demand materializes because the good being produced and sold generates some utility for the consumer; the
consumer is willing to pay some positive price for the privilege of owning the good in question. In an input
market factors of production are demanded only because they can be employed to produce an item of value.
The demand for inputs is therefore a derived demand based not upon the immediate, innate value of the input to
a firm, but upon the value of some other good that it can be employed to produce.
Our examination of these issues begins with the demand side of an input market. Because a firm must hire
labor, buy raw materials, and invest in machinery, it is the demander of productive inputs. Its demand is not,
however, unlimited. It makes its employment decisions on the basis of least-cost combinations of inputs
defined by its production function and the prices of those inputs. The derived demand for any input will
therefore result from (1) the cost-minimizing behavior of profit-maximizing firms and (2) a marginal-
productivity theory of income distribution.
The final section of Chapter 12 will show how this notion of derived demand can be used in a market
context. It will, in particular, play derived demand against alternative input supply schedules.

II. LEARNING OBJECTIVES

After you have read Chapter 12 in your text and completed the exercises in this Study Guide chapter, you
should be able to:
1. Compile a list of questions concerning the distribution of income and the factors that help to
determine the shape of this distribution. Differentiate between the terms income and wealth as they are
used in economics.
2. Recognize the major sources of income and the major reservoirs of wealth in the United States.
Describe who owns the factors of production which generate this income and wealth.
3. Establish a role for government in redistributing income and wealth using taxation and transfer
payments.
4. Define the notion of a derived demand for a factor of production, and explain why the demands for
factors are interdependent. That is, explain why the demand for any single factor depends on the level of
use of other inputs in the production process.
5. Show how the demand curve for an input is represented by its marginal revenue product schedule,
i.e., explain why the derived demand for any input can be found by multiplying the marginal product of
that input by the marginal revenue of output.
6. Show precisely why, in cases of perfect competition, the marginal revenue product of any input is
equal to the competitive price of output multiplied by its marginal product. Then show how the
imperfectly competitive case differs from this.
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7. Demonstrate why the least-cost rule describes an optimal combination of factors for firms to use.
Further demonstrate that the firm that hires all inputs up to the point at which their prices equal their
marginal revenue products will guarantee that (1) it is producing the profit-maximizing output and (2) it is
incurring the least cost; i.e., (1) the marginal revenue of its sales will equal the marginal cost of its
production, and (2) the least-cost rule will be satisfied.
8. Show how the market derived-demand curve for any input is equal to the horizontal sum of the
marginal revenue product curves of all the firms which employ that input. Recall that a market supply
curve for any good, and so for any factor, is equal to the horizontal sum of the individual factor owner’s
supply curves.
9. Illustrate how interaction between the supply and the demand for factors of production determines their
market prices. Explain why the distribution of income is the result of the workings of supply and demand
in an economy’s input markets.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definition in column B.
A B
__ Income 1. Means that the demand for a factor of production depends upon the demand for
distribution the final product.
__ Income 2. The firm will choose an optimal combination of inputs such that the ratios of
the marginal products to the prices of the inputs are equal for all inputs.
__ Wealth 3. Direct payments from government to individuals that are not in return for
current goods and services.
__ Dividend derived 4. Refers to the flow of wages or things of value earned by a person or household
during a given time period.
__ Transfer 5. Consists of the net dollar value of assets owned at a point in time.
payments
__ Personal income 6. Equal to market income plus transfer payments.
__ Marginal 7. The addition to total output when the firm hires an additional unit of a single
product factor of production.
__ Law of 8. Examines the determination of income in a society.
diminishing
returns
__ Marginal 9. States that as the firm hires additional units of an input, eventually the marginal
revenue product product of that input will fall.
__ Derived demand 10. The product of marginal revenue and marginal product.
__ Least-cost rule 11. A firm's demand for inputs that is derived indirectly from the consumer demand
for its final product.

IV. SUMMARY AND CHAPTER OUTLINE

This section summarizes the key concepts from the chapter.

A. Income and Wealth

1. The theory of the distribution of income is concerned with (1) the determination of income, and (2) the
allocation of total product among factors of production. Both of these questions are important; we need to
understand how income is generated in an economy, and then how these wages, rent, interest, and profits are
distributed across the owners of labor, land, capital, and entrepreneurial ability.
2. Income is a flow of money; wealth is a stock of accumulated economic assets. Remember that a stock
measure of any economic variable describes the total quantity of the variable at a particular point in time; a
flow measure describes the accumulation of an economic variable over a period of time. Both of these
measures are important in describing how the returns to factors are distributed across a society.
3. Sometimes, governments take actions to redistribute income and wealth in a society. This decision is a
normative one and usually occurs when policymakers have determined that there is significant inequity in the
distribution of income and wealth, or when some market failure has occurred. The two most popular tools used
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to achieve this redistribution are taxes and transfer payments. Governments collect money as taxes and return
it to people in the form of direct payments that are not in return for current goods and services.

B. Input Pricing by Marginal Productivity

1. The demand for any factor of production is a derived demand, which means that the demand for the factor
depends upon, or is derived from, the demand for the final product that it helps to produce. For example, the
demand for coal miners depends upon the demand for coal. Increased concern over acid rain and other
ecological problems has decreased the demand for coal, and hence decreased the demand for coal miners. The
demand for computer chips depends upon the demand for computers. The explosion in the popularity and use
of personal computers in the past decades has increased the demand for computers, and hence increased the
demand for computer chips.
2. The demand for any input depends directly, and most importantly, upon the productivity of that factor.
Take a moment to review some of the production theory from Chapter 6: A production function describes how
inputs are transformed into output. Production can be measured in several ways, but the key to our analysis is
marginal product, which is defined as the addition to total output that occurs when a firm hires an additional
unit of an input. Remember that the law of diminishing returns states that as additional units of an input are
added to a production process in the short run, eventually marginal product will fall. This means that the
marginal product schedule is downward-sloping, at least over some levels of output.
Given this description of the production process, the demand for an input will be defined by its marginal
revenue product (MRP). Marginal revenue product measures the addition to total revenue that occurs when a
firm hires an additional unit of an input. MRP translates marginal product, which is measured in output units,
to a meaningful dollar figure. To calculate MRP, multiply the marginal product of the input by the marginal
revenue.
3. The derived demand for any factor in a perfectly competitive industry is the (multiplicative) product of the
price of output and the marginal product at each level of factor employment; this is simply a consequence of the
horizontal demand curve faced by perfect competitors, which guarantees that price equals marginal revenue.
However, in an imperfectly competitive industry, P > MR because the firm must lower the price of all units
sold in order to sell additional units of output. (Remember that the imperfect competitor is able to charge the
maximum price that the market will bear at the optimal level of output.)
4. The least-cost rule states that a firm will hire its optimal combination of inputs when each input’s
marginal revenue product is equal to its price. This means that the last dollar spent on each input will yield the
same marginal productivity. Suppose input A is used to produce output X. Then,

MRPA = PA ==> MRX x MPA = PA ==> MPA / PA = 1 / MRX

The same expression can be written for each of the other inputs used to produce X; thus the ratio of the
marginal product of each input to its price must be equal to the inverse of the marginal revenue of good X.
Under these conditions the firm will (a) be producing the profit-maximizing output and (b) be operating at least
cost.
Suppose that you are producing widgets using labor and capital. Suppose further that the marginal product
of the last worker was 100 widgets, and you pay workers $50 per day. The marginal product of capital was 300
widgets, and you pay $100 per day for each unit of capital. Finally, suppose at this point you have exhausted
your budget on these two inputs.
Note the problem here: Capital is three times as productive as labor but only costs twice as much! The
least-cost rule is violated; you could have produced the same output with lower costs by using less labor and
more capital. Or, you could have produced more output with the same total expenditure by using less labor
and more capital. When the least-cost rule does not hold, any firm can reallocate its resources to lower costs
and increase profits.
5. The market demand curve for any input is the horizontal sum of the derived demand curves of all firms
employing that input. Likewise, the market supply curve for any input is the horizontal sum of the supply
curves of all factor owners selling that input.
6. As in any other market we have discussed, given demand and supply curves, we can describe an
equilibrium price and quantity exchanged in the market for a factor of production. Thus, the distribution of
income in an economy is at least in part determined by market forces. Individuals and households sell the
factors that they own in input markets; relative scarcity in these input markets combines with need to determine
the returns to resource owners.
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7. In spite of the importance of this analysis, other questions surrounding the distribution of income and
wealth remain unanswered. For instance, how is the initial distribution of factors determined? How does
government policy interact with market forces? These issues will be discussed in greater detail in the next two
chapters.

V. HELPFUL HINTS

1. Income and wealth are both important concepts in economics. They both measure the value of resources
available to individuals and households in an economy. However, income is a flow concept. It measures the
amount of money that accrues to a resource over a period of time. Wealth is a stock concept. It measures the
value of resources at a particular point in time. It is critical that you see the difference between these measures
and use each when appropriate.
2. Your text authors point out the importance of the interdependence that exists among factors of production,
but it bears repeating here. This interdependence occurs because most inputs in a production process are
complements, at least to some extent. This means that the inputs are used together to produce output.
Although there is often some substitutability across factors, it is rare that inputs are perfect substitutes. That
is, it is rare that a firm could use all land and no labor, or all labor and no land, for example, to produce a
product. Farmers are able to marginally reduce acreage and increase the number of farmhands hired, or vice
versa, and hold output fixed. However, all land and no labor, or all labor and no land, will yield zero output.
This is an important concept to consider, because it affects the way we think about a factor’s productivity
and value to the firm. When the North American Free Trade Agreement (NAFTA) was being debated in the
United States, many opponents lamented the fact that workers in Mexico and the Caribbean earn much lower
wages than workers in the United States and predicted the wholesale movement of many industries upon
passage of the agreement. What they failed to realize was that workers in these regions are paid less because
they are much less productive than their U.S. counterparts. An important reason for this lower productivity
involves the notion of factor interdependence. Workers in other countries have much less capital equipment and
technology to work with; their productivity will tend to remain lower as long as this is the case.
3. The decision rule for input employment is parallel to the firm’s profit-maximizing output rule. If we think
about marginal revenue as the amount of money that flows into the firm when it sells an additional unit of
output and marginal cost as the amount of money that flows out of the firm when it sells an additional unit of
output, then the general decision rule says produce until the amount coming in is equal to the amount going
out on the margin. Likewise, if we think about marginal revenue product as the amount of money that flows
into the firm when it hires an additional unit of input and factor price as the amount of money that flows out of
the firm when it hires an additional unit of input, then this decision rule also says to hire inputs until the
amount coming in is equal to the amount going out on the margin. This very general rule can be applied to
many economic decisions.
4. For a more extensive discussion of the alternative shapes of supply curves in factor markets, return to
Chapter 8 in your textbook, which describes perfectly elastic, perfectly inelastic, and backward-bending supply
curves.

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.

A. Income and Wealth

1. Income refers to:
a. total cash expenditures made by households over the course of a year.
b. the net dollar value of assets owned at a point in time.
c. payments from households to governments.
d. the total value of a stock portfolio owned by an investor.
e. total flow of wages or other things of value earned by a person or household over the course of a year.
2. Wealth refers to:
a. total cash expenditures made by households over the course of a year.
b. the net dollar value of assets owned at a point in time.
c. payments from households to governments.
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d. the total value of a stock portfolio owned by an investor.

e. total receipts or cash earned by a person or household over the course of a year.
3. The single most important asset of most households in the U.S. is:
a. a home.
b. a stock portfolio.
c. a car.
d. savings account balances.
e. expected social security payments.
4. Severe recession in the northeast coupled with a decline in the defense-oriented manufacturing base led to a
severe decrease in the demand for housing in Connecticut in the early 1990s. This meant that homeowners’:
a. wealth declined due to the decreased price of housing.
b. income declined due to the decreased price of housing.
c. wealth increased as the price of housing returned to a more normal level.
d. transfer payments from the state increased.
e. income declined due to the decreased supply of housing available.
5. The theory of income and wealth distribution analyzes:
a. the problem.
b. the how problem.
c. the for whom problem.
d. none of the above.

B. Input Pricing by Marginal Productivity

6. During the 1960s and 1970s, as the baby boom generation flowed through grade school, high school, and
college, the demand for teachers increased. This describes:
a. a derived supply of teachers.
b. a derived demand for teachers.
c. an increase in the supply curve of teachers.
d. a decrease in the demand curve for teachers.
e. none of the above.
7. Which of the following examples illustrates the law of diminishing returns at a fish packing plant?
a. The firm expands its plant facility in order to take advantage of economies of scale.
b. The firm hires additional workers for the third shift but finds that marginal product falls with each
additional worker.
c. An increase in interest rates increases the fixed costs of the firm’s operations.
d. The firm starts using cod instead of halibut for its frozen fish filets.
e. All the above describe diminishing returns.
8. If inputs A, B, and C are used together to produce product X, then the marginal product of input A is the:
a. extra output of X resulting from the employment of 1 extra unit of A, inputs B and C being increased
proportionately.
b. amount of input A required to produce 1 extra unit of X, the amounts of inputs B and C being held
constant.
c. extra output of X resulting from the employment of 1 extra unit of A, the amounts of inputs B and C
being held constant.
d. amount of input A required to produce 1 extra unit of X, the amounts of inputs B and C being
increased proportionately.
e. none of the above.
9. The marginal revenue product of input A used to produce output X is the:
a. marginal product of A multiplied by the price of A.
b. average product of A multiplied by the price of X.
c. marginal product of A multiplied by the quantity of X produced.
d. average product of A multiplied by the marginal revenue of X.
e. none of the above.
The production function in Table 12-1 describes the relationship between the number of workers employed in a
widget factory per day and total product. Widgets are sold in a perfectly competitive market. Use Table 12-1
to answer questions 9 through 11.
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TABLE 12-1
Quantity
of Labor Total Product
0 0
3 60
4 75
5 80
6 80
7 76
8 70

10. Diminishing returns set in after the:

a. second worker.
b. third worker.
c. fourth worker.
d. fifth worker.
e. sixth worker.
11. If the price of labor is $150 per day and the price of widgets is $10, how many workers should this firm
hire?
a. 0.
b. 2.
c. 3.
d. 4.
e. 5.
12. If the price of labor falls to $50 per day while the price of a widget remains fixed, how many workers
should this firm hire?
a. 0.
b. 2.
c. 3.
d. 4.
e. 5.
13. A firm operates in conditions of imperfect competition. The price of one of the factors of production,
input A, is $10; its marginal product is 5. If this firm were operating at its profit-maximizing output, then the
marginal revenue from the sale of X must be equal to:
a. $1.00.
b. $1.50.
c. $2.00.
d. $5.00.
e. $10.00.
14. Given the information provided in question 12, the marginal revenue product of input A must have been:
a. $1.00.
b. $1.50.
c. $2.00.
d. $5.00.
e. $10.00.
15. The firm from question 12 also uses input B, whose marginal product is 100 at the current usage level.
The price of input B must be equal to:
a. $1.
b. $2.
c. $5.
d. $100.
e. $200.
16. Consider a monopoly. The price of one of its inputs, input A, is $10, and the marginal product of A is 5.
The price of its output is $2. The firm has satisfied the least-cost rule for input employment. This firm is:
a. not producing its maximum-profit output and should contract production.
b. not producing its maximum-profit output and should expand production.
c. producing its maximum-profit output at least cost.
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d. producing its maximum-profit output but could reduce its costs by employing less of input A and
more of its other inputs.
e. producing its maximum-profit output but could reduce its costs by employing more of input A and
less of its other inputs.
17. Return to the data provided in question 15. If you were told that marginal revenue must be one of the five
following dollar amounts, then you would know that marginal revenue must be equal to:
a. $1.
b. $2.
c. $3.
d. $4.
e. $5.
18. Now alter the information provided in question 15 in one respect only: assume that the firm operates in a
perfectly competitive industry. Which alternative in question 16 would now be correct:
a. $1.
b. $2.
c. $3.
d. $4.
e. $5.
19. The least-cost rule for a firm making an optimal input employment decision using inputs A and B states:
a. MPA / PA = MPB / PB.
b. MPA ¥ PA = MPB ¥ P B.
c. MUA / PA = MUB / PB.
d. MRPA = MRPB.
e. none of the above.
20. The market demand curve for labor in an economy is the:
a. vertical summation of the individual firms’ marginal product curves.
b. horizontal summation of the individual firms’ marginal revenue product curves.
c. horizontal summation of the individual firms’ marginal cost curves.
d. inverse of the marginal revenue curve.
e. perfectly elastic demand curve at the market price.
21. Consider a simple, one-good economy with two factors of production—one of fixed supply and one of
variable supply. If production in this economy were to display constant returns to scale, then:
a. each factor should earn a return based on average productivity.
b. the returns to both factors sum to a total which exceeds total output.
c. the sum of the factor shares equals total product.
d. the area under the total product curve is total output.
e. both factors should receive the same return.
22. According to John B. Clark’s theory of income distribution, if 10 units of a particular input were
employed, then the price paid to each of those units should be equal to the value of:
a. the average of the marginal products of each of the 10 units.
b. its own marginal product.
c. the marginal product of the tenth unit.
d. the average product of the 10 units.
e. none of the above.
23. The marginal revenue product of an input is:
a. the selling price of the last unit of output.
b. the increment of total revenue resulting from the use of an additional unit of input.
c. used in determining marginal product.
d. none of the above.
24. If a unit of land costs $1 and a unit of labor costs $2 in the production of wheat, then the wheat producer is
at a least cost position when the:
a. marginal product of land is 2 times the marginal product of labor.
b. quantity of land is 1/2 the quantity of labor.
c. marginal product of labor is 2 times the product of land.
d. impossible to tell unless the price of wheat is known.
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VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in this chapter.

A. Income and Wealth

1. a. Income is defined as the amount of money received from all sources during a given period of time (a
year, a month, etc.). In the spaces provided below, list the major sources of income in the United States
(labor income, rent, dividends, interest, and transfer payments) in the order of their importance.
(1)
(2)
(3)
(4)
(5)
b. Wealth consists of the net dollar value of assets owned at any particular time. In the spaces provided
below, list three major tangible assets and three major financial assets that comprise wealth in the United
States in the order of their importance.
Tangible assets:
(1)
(2)
(3)
Financial assets:
(1)
(2)
(3)

B. Input Pricing by Marginal Productivity

2. Suppose that good X is produced from three inputs, A, B, and C; a very small portion of the production
function is recorded in Table 12-2.

TABLE 12-2
Employment Levels
Output A B C
200 10 30 20
203 10 31 20

a. We can infer from Table 12-2 that (the MP of X is 3 / the MP of A is 3 / the MP of B is 3 / the MP
of C is 3).
b. If the employment of some input such as B were gradually to increase, then we should expect that the
marginal product of B would gradually (increase / decline) because of the (law of diminishing returns /
relative scarcity of B that would result in the production process). Similarly, if the quantity of B
employed were to decline, then we should expect that the marginal product of B would (increase / decline)
because of the (law of diminishing returns / relative scarcity of B that would result in the production
process).
c. If the employment of some input such as B were gradually to increase, with the employment of inputs
A and C held constant, then we should expect to see the marginal products of A and C (increase /
decrease) because of the (law of diminishing returns / relative scarcity of A and C that would result
in the production process). This exercise helps to illustrate the (independence / interdependence) of
input productivities.
3. Suppose that a firm is satisfying the least-cost rule with respect to inputs A, B, and C and that it wants to
find out if it is at its maximum-profit output level. To do this, it can look at any one of its inputs—say, input
A. A’s price might be $4 per unit, for example, and its MP might be 3. Assume that the firm knows that the
marginal revenue from the sale of X is $1.
a. Under these conditions, A’s MRP is ($1 / $2 / $3 / $4 / $7 / $12). Since it costs ($1 / $2 / $3 / $4 /
$7 / $12) to buy that last unit of A, its employment (added $1 to / subtracted $1 from / did not
change) total profit. The firm, remember, is satisfying the least-cost rule in making its employment
decisions. It follows, therefore, that the same conclusion would have been reached had we looked at input
B or input C. Hence, in the given circumstances, the firm (definitely is / definitely is not / may or may
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not be) earning maximum possible profit. In order for it to move toward higher profit, in fact, it should
(reduce / increase) its output by (reducing / increasing) its employment of all inputs.
b. Now try a different example to illustrate the point more fully. Suppose that the MPs of A, B, and C
are, respectively 12, 8, and 2. Let their prices be, respectively, $6, $4, and $1. The firm (is / is not),
therefore, producing its current output at minimum cost.
c. Continue this second illustration by assuming that the marginal revenue from the sale of X is equal to
$1. Input A’s MRP would therefore equal ($12 / $10 / $8 / $6 / $4 / $2). Input B’s MRP would
meanwhile equal ($12 / $10 / $8 / $6 / $4 / $2). The MRP for input C would be ($12 / $10 / $8 / $6 / $4
/ $2). This firm (is / is not) producing the profit-maximizing output. To achieve this maximum, it
should (increase / decrease) its output by (increasing / decreasing) its employment of (input A only /
input B only / input C only / all inputs simultaneously).
d. As the firm makes these adjustments in employment, the marginal revenue products of all inputs (fall
/ rise). The increase in the employment of each input should be halted when each MRP has (fallen below /
reached equality with / risen above) the price of the (input / finished product).
4. Consult Table 12-3. The outputs of identical fields of corn are recorded there for a variety of levels of
employment of labor. Let there be 10 workers in an economy defined by the two cornfields, and let the world
determine the price of corn at $2.

TABLE 12-3
Marginal
Marginal Revenue
Labor Corn Output Product Product
Employed (bu) of Labor of Labor
0 0 n/a n/a
1 10 ___ $___
2 19 ___ ___
3 27 ___ ___
4 34 ___ ___
5 40 ___ ___
6 45 ___ ___
7 49 ___ ___
8 52 ___ ___
9 54 ___ ___
10 55 ___ ___

a. Fill in the “Marginal Product” and “Marginal Revenue Product” columns of the table. The numbers
that you record there will be used to demonstrate that paying labor (the only input here) its marginal
revenue product will result in a level of output that maximizes the value of the corn crop in terms of the
world price.
b. Suppose, initially, that seven workers toil in one field (field A) and three toil in the other (field B) .
The output of field A would be ___ bushels worth $___; each worker, if paid his or her marginal revenue
product, would receive $___. The output of field B would meanwhile be ___ bushels worth $___; each
worker there would receive $___ . In response to the wages that you computed, you should expect that
workers would want to move (from A to B / from B to A).
c. Suppose that the workers do indeed move so that four workers remain to work field A while six work
field B. Output of field A would fall to ___ bushels with a value of $___, and output of field B would
climb to ___ units worth $___ on the world market. The total value of output would climb from $___ to
$___.
d. To equalize the wages paid to workers in both fields so that there will be no incentive for workers to
want to switch from one to the other, ___ workers would have to work each field. Were that the case, total
output would climb to ___ bushels worth $___ and each worker would earn $___. There (exists another /
does not exist any other) distribution of workers that would increase the output of corn and thus increase
the value of the economy’s production on the world market.
5. You are once again a consultant on profit maximization. What would you recommend in each of the five
cases listed in Table 12-4?
In each case, the production of some good X depends only upon the employment of inputs A and B.
Assume for each case that the marginal product of input A is constant and equal to 3 and that the marginal
product of B is constant and equal to 9. The heading “MR from Sale of X” in Table 12-4 refers to marginal
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revenue at the current level of output and sales. Similarly, the headings “Price of A” and “Price of B” denote
the prices which the firm must pay for inputs A and B.
Indicate, for each case, whether or not the firm has achieved a position of maximum profit. Write “yes” or
“no” in the column provided. Use the following numerical codes to indicate, in the last column, what is wrong
with the firm’s present position.
1 = Present position is the correct one.
2 = For present output, employment of A is too high, employment of B too low.
3 = For present output, employment of A is too low, employment of B too high.
4 = Reduce output by employing less of both A and B.
5 = Increase output by employing more of both A and B.

TABLE 12-4
MR from At
Sale Price Price Maximum
Case of X of A of B Profit? Answer
A $1 $2 $10 ___ ___
B 2 6 18 ___ ___
C 3 12 18 ___ ___
D 4 9 18 ___ ___
E 5 21 54 ___ ___

6. The market demand for any input is the (vertical / geometric / horizontal) sum of the individual demand
schedules of all the firms interested in employing that input; i.e., the sum of their (marginal product /
marginal revenue product / marginal utility) schedules.
More specifically, suppose that there are only three firms interested in employing input A, and that these
firms sell their output, X, in a perfectly competitive market. (There should be more firms in a perfectly
competitive market, but for the sake of illustration here we will keep things simple.) The firms’ production
functions are given in Table 12-5.

TABLE 12-5
Total Total Total
Quantity of Product Product Product
Input A Firm 1 Firm 2 Firm 3
1 15 5 2
2 29 15 7
3 42 30 17
4 54 50 25
5 65 65 30
6 75 75 30

a. If the price of input A is $10, and the price of X is $1, what is the optimal quantity of input A for
each firm to hire?
Firm 1 = ___; Firm 2 = ___; Firm 3 = ___.
b. If the price of input A rises to $15, and the price of X remains at $1, what is the optimal quantity of
input A for each firm to hire?
Firm 1 = ___; Firm 2 = ___; Firm 3 = ___.
c. Using this information, draw a market demand curve for input A in Figure 12-1.
d. Suppose that the market supply of input A is fixed at 15 units. Draw the market supply curve in
Figure 12-1. The equilibrium price in the market for input A is $___ and the quantity exchanged will be
___.
e. The market supply curve for input A is (perfectly elastic / perfectly inelastic). This means that
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Figure 12-1

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.

1. List and explain two factors that help to determine the distribution of income in an economy.
2. Which factor of production receives the greatest portion of national income in the United States? Given the
small number of people who control land, capital, and entrepreneurship, why might the government step in to
redistribute this income? What methods might the government use?
3. Explain in your own words how declining interest rates affect the incomes and wealth of (1) many older,
retired people and (2) younger families with children. Who benefits from lower interest rates and who loses?
4. Why do we say that there is a derived demand for factors of production?
5. Consider the Happy Firm, which produces baseball caps using labor and capital. Presently, MPL / P L >
MPC / P C . Carefully explain why this is not optimal for the firm. That is, why should the firm change its
mix of labor and capital?
6. Reconsider Figure 12-7 from your textbook. Your authors explain that “it is the amount of wealth rather
than the rate of return that makes the rectangle of the top wealthholders so large.” Use this idea to explain the
adage, “Shirt sleeves to shirt sleeves in three generations.”

IX. ANSWERS TO STUDY GUIDE

QUESTIONS

III. Review of Key Concepts

8 Income distribution
4 Income
5 Wealth
11 Derived demand
3 Transfer payments
6 Personal income
7 Marginal product
9 Law of diminishing returns
10 Marginal revenue product
1 Derived demand
2 Least-cost rule

VI. Multiple Choice Questions

1. E 2. B 3. A 4. A 5. C 6. B
7. B 8. C 9. E 10. A 11. D 12. E
13. C 14. E 15. E 16. A 17. A 18. C
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19. A 20. B 21. C 22. C 23. B 24. C

VII. Problem Solving

l. a. (1) Labor income
(2) Transfer payments
(3) Interest
(4) Dividends
(5) Rent
b. (1) Own home
(2) Rental property
(3) Motor vehicle
(1) Interest-earning accounts
(2) Equity in business
(3) Stocks and mutual funds
2. a. the MP of B is 3
b. decline, law of diminishing returns, increase, law of diminishing returns
c. increase, relative scarcity of A and C that would result in the production process, interdependence
3. a. $3, $4, subtracted $1 from, definitely is not, reduce, reducing
b. is
c. $12, $8, $2, is not, increase, increasing, all inputs simultaneously
d. fall, reached equality with, input
4. a. See Table 12-3.

TABLE 12-3
Labor Corn Mrp
Employed Output of Labor
(bu)
0 0 n/a
1 10 $20
2 19 18
3 27 16
4 34 14
5 40 12
6 45 10
7 49 8
8 52 6
9 54 4
10 55 2

b. 49, $98, $8, 27, $54, $16, from A to B

c. 34, $68, 45, $90, $152, $158
d. 5, 80, $160, $12, does not exist any other
5. a. no, 3
b. yes, 1
c. no, 2
d. no, 5
e. no, 4
6. horizontal, marginal revenue product
a. 6, 6, 3
b. 1, 5, 0
c. See Figure 12-1.
d. See Figure 12- 1. $10, 15 workers
e. perfectly inelastic. This means that workers still supply the same quantity of labor at any wage;
workers will not respond to changes in the wage rate.

VIII. Discussion Questions

1. Market supply and demand and government redistribution policies.
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2. Labor receives the greatest portion of national income. To redistribute income accruing to land, capital,
and entrepreneurship, the government might place higher taxes on this income, to be used for government
welfare programs.
3. Declining interest rates hurt many people who are elderly or retired by lowering income earned on savings.
Declining interest rates help younger families with children by making borrowing (particularly mortgage
borrowing for home purchases) less costly. Borrowers benefit from lower interest rates but savers suffer.
4. We say there is a derived demand for factors of production because the demand for the factors is dependent
upon the demand for the final product. Without a demand for the good that the factor is used to produce, there
would be no demand for the factor.
5. This situation is not optimal for the firm because the last dollar spent on labor was more productive than
the last dollar spent on capital. If the firm shifted some resources from capital to labor, total output would
increase without any increase in expenditure.
6. This adage implies that it is difficult to move from the middle to the upper class. Because people in the
upper class have more capital assets, and because they are willing to undertake more risky investment projects,
they are able to build on their wealth much more quickly than someone in the middle class. Because people in
the middle class have a smaller pool of wealth to begin with, and because they invest more conservatively, they
may be unable to hurdle class boundaries.

Figure 12-1
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